Monday, March 5, 2007

Good news for long term investors! The market is down!?

For a retiree like myself, with no income but my investments, a market like the one over the last couple of weeks can easily cause a bit of panic. If you extrapolate this trend, I could be working at Mickey D's within a few years. Consequently there arises in your gut the desire to sell. It is this instinct, and an inverse one in the booming market, that causes most investors to underperform the market averages.

Invariably, at times like this, my colleagues come by to visit, because they know I enjoy tinkering in the market. The conversation invariably goes something like this:

Them: How 'bout this market?
Me: Wow, a bit scary isn't it?
Them: Yeah, so what are you doing, selling?
Me: Oh, I'm just working my system of diversification, dollar cost averaging, and rebalancing, which at times like this mean I'm generally buying.
Them: So, you are optimistic? You're pretty sure that the market has bottomed?
Me: Well, I'm optimistic in the long term, but who knows if the market is near the bottom? I'm just trying to keep the emotion out of it and working my system.
Them: Well, I'm thinking of selling until I'm surer what the market is going to do.
Me: If you do that, I predict you'll start buying just when the market hits the next peak.
Them: Oh, no, I'll reinvest when I'm sure the market is on an upward trend.
Me: Right, I think that is what I just said.

It is amazing how consistently this conversation plays out with each market dip. And each time, I become more convinced that it requires a disciplined, mechanical system to me a successful invester. Trying to predict where the market is going over the short term is impossible and is a recipe for underperforming the market.

So, remember. Set up a diverse allocation that makes sense for you in the long term. Dollar cost average. Rebalance. Above all, don't try to change your system in times of stress. Particularly so, if all the "experts" are telling you it is clear where the market is headed tomorrow or next week. When all the experts are in agreement, they almost invariably are wrong.

1 comment:

jonathanmmoreland said...

In your most recent post, you briefly mentioned diversification. While I always knew that diversifying your portfolio reduced the risk you were holding in your portfolio, it wasn’t until recently that I understood how much. Risk is measured by standard deviations. The more widely distributed the expected returns of an individual stock, the more risky it is. The formula (please excuse me for this) is

σ = [∑(ri – expected rate)2 * probability of ri]1/2.

For example, if you have a stock that has a 20% probability of achieving 2% returns, 60% probability of achieving 10% returns and 20% probability of achieving 20% returns, the formula would read

σ = [(.02-.104)2 (.2) + (.10-.104) 2(.6) + (.2-.104) 2 (.2)] ½.

The magic of diversification is that it significantly reduces the standard deviation of expected returns and just slightly lowers your expected returns. For example, a portfolio that is made up of two negatively correlated stocks with standard deviations of (S1) 20% and (S2) 13.4% and expected returns of, respectively, 17.4% and 1.7%. Assuming each stock takes up 50% of your portfolio, the weighted average of these two stocks’ expected returns = 9.6%. No you plug this new expected return into the σ formula and your new standard deviation is 3.3%. This means that you now have a portfolio with a 9.6% expected return and a 95% probability that the overall return will be 3<9.6<16.2 (this is because there is a constant 95% probability that your actual return will land within 2 standard deviations of your expected return) as opposed to a stock that has an expected return of 17.4% but a 95% chance that your actual return will be somewhere between
-22.6% and 57.4%.